The Benevolence of the Baker: Fair Pricing under the Threat of Customer Anger

50 Pages·2003·0.33 MB·English

The Benevolence of the Baker: Fair Pricing under the
Threat of Customer Anger
Julio J. Rotemberg∗
This version: November 3, 2003
Abstract
Isupposethatanactorisconsideredfairifotheractorscannotrejectthehypothesis
that the first actor is somewhat benevolent towards them. Aside from being consis-
tent with some observations in experimental games, this approach can explain several
featuresofpricingwhenconsumersjudgetheextenttowhichsuppliersarealtruisticto-
wardsthem. Undersomeconditions,thisexpectationoffirmaltruismcanexplainprice
rigidity while also providing novel explanations for third degree price discrimination
and for the existence of “temporary sales”.
∗HarvardBusinessSchool,SoldiersField,Boston,MA02163,[email protected]. IwishtothankRafael
Di Tella and participants at the workshop on “Microeconomic Pricing and the Macroeconomy” hosted by
the Central European University for comments on an earlier draft.
“... man has almost constant occasion for the help of his brethren, and it is in vain
for him to expect it from their benevolence only... It is not from the benevolence of the
butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their
own interest. We address ourselves, not to their humanity but to their self-love...” Adam
Smith, The Wealth Of Nations
Adam Smith was surely right in proclaiming that suppliers’ hope for material gain pro-
vides the main impetus behind the supply of goods. However, this still leaves open the
question of whether the benevolence of suppliers plays any role at all in market exchanges.
Certainly, many firms spend resources proclaiming this benevolence towards their customers.
Johnson & Johnson, for example makes an effort to tout its 50-year old one-page “corpo-
rate credo” which begins with: “We believe our first responsibility is to the doctors, nurses
and patients, to mothers and fathers and all others who use our products and services. In
meeting their needs everything we do must be of high quality. We must constantly strive
to reduce our costs in order to maintain reasonable prices.” Shareholders are mentioned
last, and the credo ends with the words “When we operate according to these principles, the
stockholders should realize a fair return.”1 It is conceivable that this firm is just “burning
money” through this publicity, but too much effort is spent emphasizing the content of this
message to make this interpretation plausible.
At the same time, consumers also appear to care about the benevolence of the firms
that they deal with. Consumers irate over price gouging often accuse the offending firms
of being “greedy” and “selfish”. A consumer who responded to a gas station that raised
its prices after the September 11, 2001 attack by picketing the station (and thereby leading
the station to close) complained that the station had failed to honor the idea that “most
Americans come together in times of trouble.2
This overt anger at price gouging is reflected in interview surveys where subjects are
asked what prices they would consider “fair”. Kahneman, Knetsch and Thaler (1986), for
1See, for example, http://www.jnj.com/our company/our credo history/index.htm.
2“Quick Stop in Waunakee is picketed” Wisconsin State Journal September 13, 2001.
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example, report that the vast majority of the people they interviewed regarded an increase
in the price of snow shovels during a snowstorm as unfair. The use of the word fairness
still leaves open the question of what it is about these price increases that people find so
upsetting. As Hochschild (1981) reports, the meaning people assign to the word fairness is
not uniform. Rather, this meaning varies both across people and across contexts. Fairness is
relatedtoavarietyofnormsofdistributivejustice, includingonesbasedonstrictequality, on
respondingtodifferencesinneed, onrewardingdifferencesininvestments, orongivingpeople
access to neutral procedures. All these meanings may be related to Aristotle’s principle of
treating equals equally but, as Hochschild (1981) says, this principle is vague in that it does
not define who is equal.
Economists have recently attempted to model fairness concerns explicitly. Rabin (1993),
in particular, models equilibrium actions in a one-shot game and supposes that agent A
regards agent B as fair if he expects B to take an action that is more generous than the other
efficientactionsthatareavailabletohim. FehrandSchmidt(1999)andBoltonandOckenfels
(2000), who try to rationalize the outcomes of laboratory experiments including those of
ultimatum games, model fairness as a direct concern for the strict equality of outcomes. The
approach in this paper is more similar to Rabin (1993) in that I focus on intentions rather
on outcomes per se. In practice, this difference in emphasis may not be all that important
because benevolent intentions by opponents can easily lead to more equal outcomes than
those that would result from more selfish intentions.
Still, capturing fairness in economic settings by supposing that it is equivalent to wanting
others to be benevolent has some advantages. One of these is that, perhaps surprisingly, the
altruism-based model I propose can explain the predominance of equal splits in ultimatum
games with utility functions that are much more selfish than those that are needed to explain
these outcomes in Fehr and Schmidt (1999) and Bolton and Ockenfels (2000). In particular,
equal outcomes arise in my setting without supposing that people prefer to have a dollar in
the pockets of their opponent rather than a dollar in their own pocket. Altruistic intentions
turn out to be a powerful force for equality when these intentions need to be demonstrated
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with deeds. The reason is that people who want to demonstrate even small degrees of
benevolence may need to be quite generous to distinguish themselves from more selfish
individuals.
Anotherbenefitoffocusingonbeneficentintentionsisthat, inthecontextofrelationships
between firms and households, this focus seems simpler than a focus on strict equality of out-
comes. Defining what it means for outcomes to be equal between a firm and a household, for
example, doesnotappearcompletelystraightforward. Moreover, differenthouseholdsbenefit
differently from the offer to sell a good at a particular price, and this further complicates the
issue of determining whether outcomes are equal. By contrast, the extent to which a firm is
altruistic towards its customers seems to be something that is amenable to discussion and
estimation in a broad range of circumstances. Empirically, too, benevolence on a firms’ part
seems consistent with what people regard as fair when it comes to pricing. Campbell (1999)
asked her respondents about the fairness of various mechanisms that a toy store could use
for allocating a single doll that it found in its warehouse just before Christmas, when the
doll was in short supply. Auctioning the doll to the highest bidder and keeping the proceeds
was widely seen as unfair. On the other hand, auctioning the doll and giving the proceeds
to charity was commonly regarded as fair. This can be interpreted as saying that benevolent
firms are seen in a better light than ones that seeks only to maximize profits, though other
interpretations may well fit these particular facts.
My aim in this paper is to analyze the consequences of a particular model of firm benev-
olence for pricing. The model is closely related to the one presented in Rotemberg (2002),
though this paper lets households have a sophisticated understanding of how benevolence on
the part of firms affects equilibrium prices while the earlier one supposed that households
used an intuitive but simple-minded model of firms behavior. The papers also differ in that
the current one emphasizes consequences for micro observations on prices while the earlier
one emphasized the aggregate consequences of monetary policy. What the papers have in
common is that, in both cases, consumers care about the extent to which firms are altruistic
towards them. If consumers believe that a firm has a minimal level of altruism, they buy
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from this firm normally. If, instead, consumers feel that the firm’s altruism is insufficient,
they reciprocate with anger.
I simplify the analysis in a number of ways, and thereby leave many open questions for
subsequent work. I suppose, in particular, that the level of benevolence that consumers
require of firms is in fact equal to the benevolence that firms feel for consumers. This seems
like a good starting point for the analysis since it implies that consumers are rational in
their expectations regarding firm behavior. It does, however, neglect the analysis of the
forces that lead firms to be altruistic as well as the analysis of how firms with different levels
of altruism fare in equilibrium.
I also make two simplifying assumptions regarding consumer anger with firms that are
seen as insufficiently altruistic. The first is that all of a firm’s customers have the same
information so that they react in the same way to a firm’s prices. The second is that the
reaction to a firm that is seen as insufficiently altruistic consists of a cessation of purchases.
What is essential about these assumptions is that there is a discrete reaction when the firm
steps over a line. In practice, this reaction often takes the form of direct protests and calls for
political intervention, both of which can be quite costly to firms. Another aspect of actual
reactions to price gouging is that customers do not all react right away in the same manner.
Rather, some outspoken customers take it upon themselves to convince others that the firm’s
actsareimmoralandthatthefirmoughttochangeitsbehaviororfacepunishment. Whether
any customers will react in this way, and whether they will garner support by, for example,
getting media attention, appears to be somewhat unpredictable in that firms often find these
reactions surprising. In my model, I capture this lack of predictability by supposing that
firms are not well informed about the consumers’ trigger points, eventhough this assumption
is not easily squared with my assumption that all consumers react in exactly the same way.
Amodeloffairpricesmustobviouslyaccountforthelackoffairnessthatpeoplefeelwhen
prices respond to the changes in demand I discussed above. Ideally, such a model would also
account for a related observation, namely that many branded goods prices remain constant
for long periods of time. This price stability seems more common among branded goods
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than among unbranded commodities, suggesting that periods of constant prices provide
information to consumers about attributes of particular firms.
On the other and, many branded goods also have prices that seem to be variable on
purpose. Branded goods firms often engage in price discrimination where different customers
pay different prices for the same good. If this is seen as unfair, and Maxwell (1995) reports
that people do see some price differences across customers as unfair, it raises questions
about the extent to which firms are even trying to be fair. In addition, many branded
goods alternate between being sold at “regular prices” and being “on special” (or having a
“rebate”). If this is also seen as unfair, one could argue that the pressure on firms to act
fairly is relatively weak. An element that gives this argument force is that there exist well
articulatedmodelsofprofitmaximizationthatrationalizetheseformsofpricediscrimination.
It turns out, however, that benevolence is also able to explain these forms of price dis-
crimination even in settings where selfish firms would charge uniform prices. Benevolent
firms prefer charging high prices to individuals with low marginal utility of income while
charging lower prices to those whose marginal utility of income is higher. This rationalizes
the common practice of offering discounts to groups that are widely regarded as less well off
such as the young and the elderly.
Intertemporal price discrimination is also advantageous to benevolent firms. Such firms
may find it difficult to earn an adequate profit if they continuously charge a price that is so
low that even individuals whose willingness to pay is low can buy it. By the same token,
they often can earn a return that is sufficient to keep them in business by selling to these
individuals on occasion, while charging a high price the rest of the time. This can rationalize
regular “specials” even in settings where the elasticity of demand of various market segments
is constant. These theoretical examples do not, obviously, prove that the observed forms of
price discrimination are due to fairness considerations. They do, however, establish that
these observations are not at all inconsistent with the importance of fairness in price-setting.
At the same time, firm altruism is consistent with constant prices - and stock-outs - in
periods where demand rises dramatically. It is common, for example, for supermarkets to
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run out of bottled water before and right after hurricanes.3
Whenstoresdoincreasetheirpricesinsuchcircumstances,andsomestoresdo,consumers
complain vociferously of “gouging”.4 These price increases may be painful to consumers not
only because they reduce their real income but also because they lead customers to regret
not having bought earlier. As long as this experience of regret is acute enough, altruistic
firms will prefer to keep their prices constant. Interestingly, this mechanism can explain
situations where prices remain constant when demand increases by a great deal, as in the
case of a natural disaster, while they vary in response to smaller increases in demand. The
reason is that an altruistic firm realizes that, in the former case, small price increases may
not be very affective at allocating goods across customers since all customers are clamoring
for the good at the same time.
The three implications of the model I just discussed above are based largely on pure
altruism, and it is important to stress that the model incorporates not only firm altruism
but also customers who become angry when firm altruism is insufficient. However, it turns
out that even when both firm altruism and consumers’ requirement that firms be altruistic
are present, firms often end up charging the price that is dictated by their altruism alone.
This result is almost certainly due in part to my assumption that the benevolence that
customers expect from firms corresponds, in the typical case, to genuine feelings that firms
actually have. This is not a full explanation, however, because the equilibrium offers in
the the ultimatum game that I study are much larger than those based on pure altruism,
even though the altruism of proposers is closely matched with the altruism demanded by
responders.
The willingness of households to punish firms they deem to be unfair does affect one
of my results concerning prices. It affects, in particular, the extent to which firms keep
their prices constant even if their costs of production change. The assumption that firms
internalize the distress of consumers whose price changes does, of course, rationalize some
3See, for example, “N.Va.’s Land Of Plenty Learns To Do Without,” Washington Post, September 21,
2003.
4See, for example, “In praise of gouging,” The Globe and Mail, January 24, 1998.
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price rigidity under pure altruism. However, the model also predicts that this price rigidity
is variable so that, in particular, the size of the minimum price increase that firms will
implement depends on the firm’s circumstances. When the firm feels that its original price is
regarded as fair by its customers it is willing to countenance small price changes, while this
is no longer true when it feels that customers are already dubious about its initial price. In
the latter case, the benefits of raising prices are lower because this might lead to consumer
anger. This rationalizes the rather diverse price increases observed by Carlton (1986) and
Kashyap (1995), which stand in contrast with the behavior predicted by administrative costs
of changing prices of the form considered in Barro (1972) and Sheshinski and Weiss (1977).
Thepaperproceedsasfollows. Thenextsectionintroducesmymodelofreciprocitybased
on altruism and shows that it can explain some experimental findings. I then turn in section
2 to a firm that sets prices for a single period. Section 3 studies a variant where the firm
is better informed about the signals available to consumers. Section 4 is devoted to price
discrimination while Section 5 deals with price rigidity in response to demand fluctuations.
Section 6 is concerned with price rigidity when firms must produce different batches with
different levels of marginal cost while Section 7 concludes.
1 A general model of “reciprocal” preferences
My focus is on consumers who purchase goods from firms. Before specializing the model to
this context, I consider a more general one where two agents move in sequence. The first
player, which will later represent a firm setting a price, chooses an action a and then the
1
second reacts by choosing a . The two agents have material payoffs, i.e. utility functions
2
leaving aside any feelings the agents have for one another, given by U and U respectively.
1 2
The two players’ actual utility is given by
W = U +λ U (1)
1 1 1 2
ˆ ¯
W = U +(λ −ξ(λ ,λ))U (2)
2 2 2 1 1
whereλ andλ representtheunconditionallevelsofaltruismofthetwoagents. Thevariable
1 2
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ˆ
λ represents the beliefs of agent 2 about λ while the function ξ takes a value substantially
1 1
¯
larger than λ if agent 2 can reject the hypothesis that λ ≥ λ and equals zero otherwise.
2 1
This means that agent 2 is willing to incur significant costs to inflict harm on agent 1 if he
¯
can reject the hypothesis that agent 1’s altruism is at least equal to λ.
In supposing that an agent is more altruistic towards agents that are altruistic in return,
this model follows Levine (1998). Two differences from his specification are worth highlight-
ing. The first is that he considers a model where agent 1’s altruism level becomes common
knowledge in equilibrium, rather than remaining random. The second is that his model is
one where agent 2’s altruism responds smoothly to the level of agent 1’s altruism. Here, in-
stead, I suppose that the response is discontinuous. I do this for two reasons, one relatively
general and the other specific to my application. In general, it appears that people’s re-
sponse to what they perceive to be ill treatment often moves almost seamlessly from passive
acceptance to violent outburst. In the context of industrial relations, for example, worker
unhappiness sometimes erupts in sudden strikes. In the case of road rage, some drivers react
with unusual force to what they see as inconsiderate driving by others.5 In the context of
pricing, firms that raise their prices by small amounts often encounter no reduction in sales
while larger price increases sometimes generate substantial resistance, including the threat
of political intervention. This too might be rationalized in other ways. However, it seems
natural to model this reaction as one of consumers who feel that the firm has “crossed the
line”.
Before discussing pricing in more detail, I consider how people with these preferences
ought to behave in some classic experimental settings. The aim is to show that these prefer-
ences can account for the contrasting outcomes in “ultimatum” and “market” experiments
reported in Roth et al (1991). In the former, equilibrium outcomes are often “fair” while
in the latter, they are often lopsided. Fehr and Schmidt (1999) and Bolton and Ockenfels
(2000) provide preferences that are meant to rationalize these outcomes, and it might be
5While I suppose that these violent reactions are the result of a drastic changes in attitude, they may
instead be due to the fact that the person who is reacting is incapable of milder reactions.
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thought on this basis that these preferences are also the best starting point for studying
fair prices. Some of the benefits of using preferences based on intentions are discussed in
the introduction. It turns out that, in addition, these preferences also have advantages for
explaining the experimental evidence, and I discuss these advantages presently.
The well known “ultimatum game” involves a “proposer” who offers a “responder” an
amount of money between 0 and a set sum A. If the responder rejects this offer both players
get nothing. If he accepts it, the responder gets the amount offered while the proposer gets
thedifferencebetweenAandthetheamountpaidtotheresponder. Standardgame-theoretic
reasoning would predict that the responder receives a negligible positive offer and accepts.
In practice, small offers are often rejected and most offers are substantial. Forsythe at al
(1994) report that over half the participants in their experiments offer A/2.
Fehr and Schmidt (1999) suppose that, when paired with agent 2, agent 1 maximizes
x −αmax(0,x −x )−βmax(0,x −x )
1 2 1 1 2
and analogously for agent 2, where x is the level of resources in the hands of agent i while
i
α and β are positive parameters. Bolton and Ockenfels (2000) consider a slightly different
utility function that also imposes a penalty for differences between x and x . It follows from
1 2
maximizing this that, as a responder, agent 1 always accepts offers just below A/2. This
means that that offers of A/2 are not motivated by the fear of having the responder turn
them down. Instead, they are due to having the proposer have a β equal to at least 1/2. The
case of β = 1/2 is a knife edge case in which the proposer is indifferent among many offers.
To obtain offers of A/2 in a robust manner, β must actually exceed 1/2. This means that,
when 2 has lower resources than 1, agent 1 must get more marginal utility from additional
resources in agent 2’s hands than from additional resources in his own.
Such a high level of regard for another’s resources (at the margin) is implausible, partic-
ularly in settings where the person one is interacting with is not one that is seen as deserving
ofcharity. Moreover, thislevelofregardhasareadilyrefutableimplication. Agentswhooffer
A/2 in ultimatum games because β > 1/2 ought also to offer A/2 in the related “dictator”
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